Articles By Bill Quackenbush

Tax Court: 7.5 Percent or 30.6 Percent DLOM?

Date: Author:

Estate of Koons v. Commissioner, 2013 Tax Ct. Memo LEXIS 98 (April 8, 2013)

In connection with a major asset sale, the decedent formed a limited liability company (LLC) and made a will under which he left the residue of his estate to a revocable trust. At the time of death, the trust owned a 50.50% total interest in the LLC, whose value was over $300 million. When the estate challenged the Internal Revenue’s deficiency determination as to estate and generation-skipping transfer taxes, the primary issue was the valuation of the trust’s interest in the LLC—which hinged on the magnitude of the applicable marketability discount (DLOM).
The decedent owned a company that was in the vending-machine business and claimed exclusive rights to selling Pepsi beverages in its territories. In 2004, the company agreed with PepsiCo. Inc. to sell its business to a Pepsi affiliate. For this purpose, the company, whose shareholders included the decedent and his four children, transferred all of its assets to a wholly owned subsidiary (the LLC) and the shareholders executed a stock purchase agreement (SPA) with the Pepsi affiliate. Among other things, the SPA specified that the LLC would sell all shares for approximately $340 million, plus working capital (the final purchase price was $352.4 million). Moreover, the LLC assumed certain environmental, health, and safety liabilities related to the company’s Florida production facility; ,and it committed to own liquid assets with an aggregate fair market value of at least $10 million and maintain a positive net worth of at least $40 million until January 2012. Importantly, the four children’s agreement to sell their company shares to the LLC was contingent on the latter’s offer to redeem their varying membership interests.
By March 2005, the date of the decedent’s death, all four children had accepted the redemption offer. At the end of April 2005, the redemptions closed, with the final payments occurring around July 2005. The decedent had contributed his membership interest in the LLC to a revocable trust established some 15 years earlier. He had amended the terms of the trust such that its beneficiaries were no longer the children, but the grandchildren, their lineal descendants and surviving spouses; shortly before his death, he instructed the trustees to vote in favor of amending the LLC’s operating agreement such that it: (1) eliminated his children as permitted transferees of membership interests; (2) eliminated the board of advisors, which included his children; and (3) for the first 15 years of the LLC’s operations, limited discretionary distributions per year to LLC members to 30% of the difference between distributable cash and income tax distributions.
Only weeks before the decedent died, in February 2005, one son wrote a letter calling the redemption offer “punitive” but expressing gratitude for the “exit vehicle” and stating that the children would “like to be gone.” He said the operating agreement “guarantees litigation.”
At the time of death, the revocable trust had a 50.50% total percentage interest in the LLC, resulting from a 46.94% voting interest and a 51.59% nonvoting interest. The redemption of the children’s interests increased the percentage to 70.93%. The LLC’s net asset value was about $317.9 million. At the beginning of 2006, it had over $200 million in highly liquid assets and owned two companies whose combined assets made up only 4% of its total assets.
Besides its interest in the LLC, which was held through the revocable trust, the estate had assets totaling over $26.6 million, which is the amount it reported on the estate tax return. The IRS issued notices to the estate initially claiming a deficiency in estate taxes of nearly $42.8 million and to the revocable trust for a deficiency in generation-skipping transfer tax of nearly $15.9 million.
The agency subsequently increased the deficiencies based on its determination that the trust’s interest in the LLC at the time of death was worth over $148.5 million. The estate and the trust challenged the notices and petitioned the federal Tax Court for review. Both sides offered valuations from notable financial experts as to the trust’s fair market value.
Gaping DLOM difference.
The parties agreed that, assuming the trust had a 50.50% total interest in the LLC and the latter had a value of some $371.9 million, the trust’s pro rata asset value was over $160.5 million. They further agreed that its actual value was less because of a lack of marketability but strongly disagreed over the size of the applicable marketability discount.
Estate and trust’s expert. The petitioners’ expert was Mukesh Bajaj, whose DLOM determination drew on his influential 2001 regression study of 88 companies. (See “Firm Value and Marketability Discounts,” 27 J. Corp. L. 89 (2001)). There, he used an equation to explain the difference between the price of the publicly traded stock of a company and the price of the same type of stock of the same company sold privately pursuant to a restriction that the buyer must wait before reselling the shares. When Bajaj applied the equation to the trust’s 50.50% interest in the LLC, he arrived at a 26.6% “initial marketability discount.” But, he said, the differences between the trust’s interest and the shares in the 88 companies required further adjustments. He added a second—4%—discount to account for certain limitations that applied to the LLC, including environmental obligations it had assumed under the SPA. Because the LLC was closely held, small, and unknown and selling an interest in it to persons who were not direct descendants required a 75% vote of its members, he applied a third—3%—discount and arrived at a 31.7% DLOM. As a result, he concluded the trust’s interest equaled the pro rata net asset value of the LLC’s assets minus 31.7%, yielding a value of approximately $110 million.
He also determined that there should be no control premium because the holder of the trust’s interest only had a 46.94% voting power and as such had not enough control to obtain “private benefits.” Even if the holder obtained a 70.42% voting interest following the redemption of the children’s interests, there were no private benefits because the operating agreement and the SPA imposed restrictions on the LLC. He also saw no reason to apply a discount for lack of control.
Government’s expert. The IRS’s expert was Francis X. Burns. He, too, considered the 2001 Bajaj study but for various reasons declined to perform a regression analysis to predict the marketability discount. As he saw it, the equation resulted from a data set of companies that earned their profits mainly from active business operations; in contrast, the LLC had only two small ones. Also, the equation explained only one-third of the variation in the discounts in the ownership interests in the 88 companies from which Bajaj had generated the equation. Moreover, all 88 transactions involved ownership interests of less than 50.50%. And, the IRS expert said, the Bajaj equation systematically overestimated the relationship between block size and the valuation discount.
Instead, Burns found that a 5% to 10% DLOM was appropriate based on a number of critical factors. Most important, the risk that the redemptions would not go through was small, he found. On the other hand, the SPA imposed obligations on the LLC related to potential environmental, health, and safety liabilities; also, it was reasonable to assume that the LLC would make cash distributions, an owner of the revocable trust’s interest would be able to force the LLC to distribute most of its assets once the redemptions closed, and most of the LLC’s assets were liquid. For all these reasons, he decided a 7.5% DLOM would be a reasonable accommodation between a hypothetical seller and buyer.
Like the petitioners’ expert, he concluded that neither a control premium nor a discount for lack of control was appropriate. Even though the voting interest at the time of death was only 46.94%, the redemption of the children’s interests was reasonably foreseeable, he said. Consequently, the voting power would increase to 70.42%. At the same time, the LLC’s major assets were cash, not operating assets, and it was unlikely that a controlling member of the LLC “could extract value above its pro-rata claim on company assets.” On the other hand, that degree of voting power allowed the owner to control the LLC’s board of managers.
Likelihood of redemption.
The petitioners and their expert objected that Burns’ low discount primarily resulted from the mistaken assumption that the redemption would occur and increase the voting interest of the owner of the trust’s interest from 46.94% to 70.42%. Although each of the four children had signed a redemption offer before the decedent’s death, the petitioners claimed these were not enforceable under applicable state law because they did not include vital terms, including the price at which the LLC would redeem the interests. Further, the son’s February 2005 letter suggested that the children did not intend to sell their interests.
The court agreed that the question of whether the redemptions were likely was pivotal to the valuations. It disagreed with the petitioners and their expert on this point and other points and credited Burns’ analysis. The redemption offers, the court said, expressly stated that the interests were redeemable at a price equal to each owner’s share of the value of the LLC’s assets; since most of the assets were cash, it was easy to establish their value and by extension the redemption price. A state court likely would have enforced the signed letters. Moreover, the LLC successfully could have sued any signer who tried to renege on the contract. What’s more, because a critical aspect of the redemption offers was to remove the children from the ownership of the LLC, a court would have ordered specific performance.
The February 2005 letter equally suggested that the children did not want to remain owners of the company; “they wanted cash,” said the court. At the same time, the LLC’s managers wanted them removed as owners. Accordingly, both sides had incentives to effect the redemptions. The petitioners tried “to create a smokescreen of uncertainty around the redemptions which did not in fact exist as of the valuation date,” concluded the court.
Burns’ assumption that the owner of a 70.42% voting interest in the LLC could order the latter to distribute most of its assets also had traction with the court. Despite the SPA’s provisions regarding liquid assets, it did not bar the LLC from distributing most of its assets. And even if the board of managers were reluctant to do so because the decedent had preferred that the LLC invest its assets in operating businesses after his death, the key was that hypothetical buyers and sellers of the trust’s interest would proceed from the knowledge that the LLC could be forced to distribute most of its assets, the court pointed out. “A majority member who could force the LLC to distribute most of its assets would not sell its interest for less than the member’s share of such a distribution,” said the court.
In this case, if the LLC’s total assets valued almost $318 million and it had to retain $40 million of the assets, per the SPA, it could distribute approximately $278 million to members. Assuming a 50.50% interest in the LLC, the holder could expect to receive about $140 million in a distribution. This amount, said the court, was the minimum sale price of the interest. Therefore, it rejected Bajaj’s $110 million valuation and adopted Burns’—and the government’s—$148.5 million valuation.
Balloon interest payments.
A secondary issue concerned a $10.75 million loan the LLC had made to the revocable trust in February 2006 to pay estate and generation-skipping transfer taxes and for which the estate claimed an interest expense deduction of over $71.4 million. The terms of the loan provided that repayment would be in installments from 2024 through 2031—a deferment that caused the interest to swell and meant the estate would have to remain active throughout the repayment of the loan. Once more, the court agreed with the IRS’s position and did not allow the deduction. There was no need to borrow the money because in 2006 the trust had a 70.42% voting interest in the LLC and the LLC had over $200 million in highly liquid assets. The trust had the power to force the LLC to make a pro rata distribution to its members, including the trust, said the court.

Proving Goodwill in Like-Kind Exchange

Date: Author:

Deseret Management Corp. v. United States, 2013 U.S. Claims LEXIS 987 (July 31, 2013)

IRS discovers DCF is a ‘double-edged’ sword. “Use at your own risk” is the lesson a financial expert for the IRS learned when she used the discounted cash flow (DCF) method to bolster the agency’s argument that the taxpayer was liable for appreciable goodwill related to a like-kind exchange.
Station swap: The plaintiff owned KZLA, the only country-music FM station in the Los Angeles market, but, when the station kept underperforming in a fast-growing market, it agreed to a station swap with another communications company. The exchange value of the assets was $185 million. The value of KZLA’s tangible assets was approximately $3.4 million, and the value of all its intangible assets, excluding the station’s FCC license and goodwill, was about $4.8 million. An appraiser calculated the value of the FCC license using the “residual fair market value” method—subtracting the value of the tangible and intangible assets from the $185 million exchange value and assigning the difference (the residual) to the FCC license. The appraiser assigned no value to goodwill claiming that: (1) legal precedent held that “broadcast stations do not possess any goodwill”; and (2) KZLA, in particular, “does not possess any other traditional manifestations of goodwill.” The license was worth nearly $176.8 million, the appraiser said.
Under I.R.C. Section 1031, a taxpayer may defer recognition of gain or loss from qualifying exchanges of like-kind property. But, under Treas. Reg. Sec. 1.1031(a)-2(c)(2), a business’s goodwill is not of a like kind to the goodwill of another business. Therefore, the nonrecognition provision does not apply. The IRS issued a deficiency notice claiming there was a goodwill value of $73.3 million on the transaction date. Ultimately, the plaintiff sued in the Court of Claims for a refund.
The court found indications of goodwill but required the IRS to show whether the goodwill was appreciable or negligible. The agency’s expert tried to isolate the income attributable to the FCC license by performing a discounted cash flow (DCF) analysis of the station, treating it as a startup. She created projections for the revenue, operating cash flow, and net free cash flow that KZLA could reasonably be expected to achieve in the market, based on past performance, market operating and financial benchmarks, as well as the performance of other radio stations in the Los Angeles market. Discounting the net free cash flow to present value, she then extracted the value for KZLA’s license. She initially found it was worth $131.4 million, which left a residual value of goodwill of $45.4 million. After correcting for errors in her cash flow projections and working capital calculation, she lowered the amount to $36.5 million.
No goodwill: The plaintiff’s rebuttal experts highlighted three errors that if corrected would increase the license value to $179.6 million, leaving no portion of the purchase price to assign to goodwill. The court agreed and in a detailed chart showed that the effect of the proposed adjustments was that there simply was nothing left for goodwill. “[T]the use of discount calculations to value goodwill represents a double-edged sword in that the numbers can demonstrate the presence or the absence of goodwill,” the court concluded.

Changes on Estate & Gift Tax Valuations

Date: Author:

There are two recent Tax Court cases that may impact estate and gift business valuations, the Estate of John F. Koons, III v. Commissioner, T.C. Memo 2013-94, and the Estate of William M. Davidson (court date pending).

In Koons, one of the issues was the selection of an appropriate discount for lack of marketability regarding an interest in an LLC. The IRS’s expert used a DLOM of 7.5%, and the taxpayer’s expert used 31.7%. Why the big difference? A stock redemption agreement was signed prior to death but not completed as of the valuation date that would give the owner substantial control over the LLC. The IRS expert assumed that the redemption would occur, but the opposing expert assumed it would not. Given the facts and circumstances surrounding the redemption, the court agreed with the IRS expert’s lower DLOM.

The case is being appealed to the 11th Circuit. The point in this case is that, if a post-valuation-date event is likely to occur, should it be taken into account in the valuation.

The Davidson case involves the use of self-canceling installment notes, or SCINs. While the case doesn’t have a court date yet, the IRS has filed a petition claiming that the estate is undervalued and owes up to $2 billion in taxes (yes, billion).

William Davidson is the late owner of the professional sport teams, the Detroit Pistons and the Tampa Bay Lightning, and also Guardian Industries (one of the country’s largest private companies). In addition to the undervaluation allegation, the IRS is questioning the SCIN technique of selling assets to heirs based on a payment schedule that includes a provision that cancels the payments when the seller dies. The recipients had to make payments to Davidson for those assets while he lived, but the debt they owed was canceled — and the assets theirs outright — when Davidson died.

While SCINs are legal, the IRS is claiming that the payments should have been higher because Davidson made errors in figuring his life expectancy, which caused the heirs to pay much less than fair market value; therefore, some of the assets qualified as gifts should be taxed. Very little has been written about the valuation of SCINs. But if the Davidson estate prevails in Tax Court, Their use will likely increase.

War over Workable Stock Appraisal Method

Date: Author:

Sullivan v Troser Management, Inc., 2013 N.Y. App. Div. LEXIS 1641 (March 15, 2013)

In nearly 40 years of banking and litigation support work we have reviewed hundreds of buy/sell agreements, many referencing the establishment of annual valuations. But it is extremely rare that owners actually establish that annual value. This New York case illustrates a worst case scenario when owners ignore their agreement to establish annual value.
Ten years of litigation over a shareholder buy-sell agreement between parties that never agreed on the value for the shares of a closely held corporation have taken the litigants through four rounds of appeal but not close to an answer as to the appropriate valuation method.
The plaintiff served as the defendant’s director of sales for the operation of a ski resort. In 1986, the parties made an agreement that promised him an 18% equity interest in the defendant’s closely held corporation if he remained employed until year-end 1991. Under a contemporaneous buy-sell agreement, the defendant had the option to buy back the plaintiff’s stock if, among other things, the employment ended.
The purchase price was to be “an amount agreed upon annually by the Stockholders as set forth on the attached Schedule A.” If the parties failed to establish an annual value, “the value shall be the last agreed upon value except that if no such agreed upon value is established for period of two years, the value shall be the last agreed upon value in- creased or decreased by reference … the company’s book value.” The agreement listed the plaintiff as a “stockholder.”
No Schedule A exists. In 2003, the plaintiff sued in state court (Supreme Court, Monroe County, which is a trial court) for specific performance of the stock issuance. Moreover, he requested an order that, once the stock was issued, the defendant had an obligation to repurchase it and a determination of the parties’ rights and duties under the buy- sell agreement. The trial court directed the defendant to issue 18% of its shares of stock to the plain- tiff, which the defendant subsequently did. The court also ordered the parties to execute the buy- sell agreement and fixed a price for the purchase.
Specifically, it valued the buy-back interest at an amount that aligned with a prior buy-out involving a different shareholder. Both sides appealed.
Volley of appeals. In 2005, the defendant sought dismissal of the complaint, arguing it was time- barred. The appellate court declined. At the same time, it granted the plaintiff’s request to overturn the lower court’s setting a price for the purchase of his shares.
In 2006, the trial court directed the defendant to repurchase the stock for approximately $110,000, based on the defendant’s claim that the method to value the stock was by prorating the value of its parent corporation among that company’s three subsidiaries. The plaintiff appealed, contending that the agreement required that the two stockholders of the defendant determine the value of the stock, not the owners of the parent corporation. He also provided a letter he had received from the defendant’s attorney in 1999 that specified a different valuation method. The appellate court ruled for the plaintiff.
In 2009, the trial court denied the plaintiff’s request for a determination that his shares “be valued on the basis of his percentage interest in the Defendant’s assets” in the event that the defendant exercised its option to buy back the shares. He advocated for the use of a net asset approach that  the state’s highest court had approved in a case about the buyout of a law firm partner pursuant to an agreement that provided for a future agreement among partners that never came into existence.
The plaintiff appealed, contending the agreement’s purchase price provision was unenforceable. The defendant presented other stock valuations. The appellate court said the plaintiff showed “as a matter of law that the stockholders have never agreed upon a value of the stock.”
Accordingly, there was no way to ascertain his share price in accordance with the terms of the buy-sell agreement. Evidence of stock valuations from other transactions was of no consequence because the plaintiff was not a party to them.
No uniform rule for valuing stock. In 2011, the trial court denied the defendant’s motion to set the stock purchase price at approximately $184,000 based on its expert’s calculation. The expert had used the same formula the plaintiff proposed in 2009.
The appellate court affirmed the denial. Its 2010 ruling notwithstanding, it stated it did not then require  a  net  asset  valuation,  a  method  the  High Court approved but did not mandate. The court clarified that its earlier decision established that the plaintiff’s shares had to be valued “on the basis of his percentage interest.” However, issues of fact as to what the appropriate method for valuing the defendants’ assets remained.
The court rejected the defendant’s claim that the buy-sell agreement’s reference to book value dictated its use to determine the price for the plaintiff’s shares. The parties never agreed on the value of the shares, and there was no adjustment to be made. “Book value does not come into play.” In this vein, it also noted that, even though, under pro- visions of the business corporation law, the plain- tiff had no right to the “fair value” of the stock, “it does not follow … that the plaintiff is entitled only to book value.”
There was “no uniform rule for valuing stock in closely held corporations,” the appellate court stated. A court must tailor the valuation method to a particular case, based on the evidence at trial.
The appellate court, however, agreed with the defendant that the trial court had erred in finding the defendant had exercised its option to buy back the shares. The plaintiff earlier had raised the issue in an inappropriate manner. A resolution of this question could wait until the defendant actually refused to buy the shares at the price the lower court set after a trial on the value of the shares, the appellate court concluded.

How Much Is A Breaching Partner Worth?

Date: Author:
When you operate a business with another person, New York considers you to be in a general partnership unless you form an entity like a corporation or limited liability company. Without a written Partnership Agreement, you can leave the partnership at any time. However, if you and your partners enter into a Partnership Agreement, then as with any contract, you need to follow its terms in order to lawfully terminate the partnership.
In the event that a partner dissolves the partnership in contravention of the Partnership Agreement, New York Partnership Law Section 69(2)(a)(II) permits the non-breaching partners to have a claim for damages for breach of the Partnership Agreement. In addition, Section 69(2)(b) permits the non-breaching partners to continue the partnership business.  Under Section 69(2)(c)(II),  the  partner who wrongfully dissolved the partnership is entitled to be paid the value of his interest in the partnership, not including the partnership’s “good will” (i.e., some of the intangible assets of the business, such as its trade name, reputation and client base), less any damages caused by his breach, and thereafter to be released from the liabilities of the partnership.
In a case that William Quackenbush, ASA, MCBA, ABAR provided expert witness testimony, there was a 3-person partnership, the partnership agreement of which provided that the partnership would continue for 50 years. For various reasons, two partners voted to dissolve the partnership before that time, which was a breach of the Partner- ship Agreement. This led to a lawsuit commenced by the “non-breaching partner.” The non-breaching partner elected to continue the partnership business under Section 69(2)(b). Therefore, the breaching partners were entitled to be paid their interest in the partnership. But, Partnership Law Section 69 does not specifically provide for the method of valuation of a partner’s interest.
So, how do you value the breaching partner’s interest? In a case of first impression in the non- breaching partner’s attorney successfully argued that fair market value of the partnership’s assets is the correct valuation method to determine the value of the partner’s interest in the partnership business.
Here, the non-breaching partner argued that the breaching partners’ interests should be valued at book value based upon the accounting principles commonly used by the partnership. However, the non-breaching partner was the person primarily responsible for the financial books and records of the partnership for the tenure of the business, and employed book value accounting principles for its records. He also argued that the Partnership Agreement provided for an exiting partner to receive book value for his interest.
The non-breaching partner’s attorney argued that the Partnership Agreement did not govern this situation because it only provided for a partner to be paid book value for his interest in the event that the partner retired or died, or the business was liquidated and sold following the retirement or death of a partner and the remaining partners choose not to continue the business. None of these events occurred because the breaching partners voted to dissolve the partnership and the non-breaching partner elected to continue the business.
The non-breaching partner’s attorney collaborated with a CPA and William Quackenbush, ASA, MCBA, ABAR, the managing director of Advent Valuation Advisors. Both experts testified that book value accounting is not a valuation convention, but an accounting convention that significantly depreciates an entity’s assets and does not reflect the company’s true value. Mr. Quackenbush opined that the language of Section 69 supported a fair market valuation. Both Mr. Quackenbush and the CPA also testified that the poor bookkeeping practices of the partnership prevented a true market value analysis. Mr. Quackenbush testified that the partnership’s recorded value of the machinery and equipment and inventory needed to be adjusted to fair market value to reflect a realistic value of the company.
Ultimately, the Appellate Division, Second Department, adopted the arguments asserted by the non-breaching partner’s attorney, holding that, “The Supreme Court did not improvidently exercise its discretion in using fair market value to determine the value of each defendant’s interest in the subject partnership pursuant to Partnership Law Section 69 (2). It is undisputed that the defendants wrongfully dissolved the subject partnership. The parties’ partnership agreement did not limit the interest of a partner who wrongfully dissolved the partnership to book value, and book value is an accounting method that does not reflect fair market value of an asset.”